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The Japanese stock market is following a classic boom/bust pattern. Many of the major players know that the boom is unsustainable, yet they feel they must continue playing. A turning point is imminent.

At the beginning of 1986, the boom started to falter because of the rising value of the yen. The impact on corporate earnings and economic activity was negative. Under the same influence, the West German stock market entered a phase of prolonged consolidation; but in Japan the upward trend accelerated sharply. The driving force was liquidity.

Liquidity can be broken down into three main components: inflows from abroad, bank lending and domestic savings. The first did not contribute directly to the boom. Foreign investment in the Japanese stock market diminished as stocks became overvalued, so that the stock market became almost a domestic affair.

Bank lending inside Japan accelerated to an annual rate in excess of 15 per cent, although commercial and industrial loan demand abated as a result of the recession. The growth of money supply accelerated to 11 per cent. The bulk of the new loans went into financial and land speculation, giving rise to the phenomenon “financial technology” to boost declining profits with the proceeds of financial speculation.

The domestic savings rate was greatly influenced by the land boom. When the price of housing rises more rapidly than wages, people have to save a larger portion of their earnings to make a down payment. On the other side, when someone sells property, the proceeds also swell the volume of savings. Thus the land boom had the perverse effect of increasing savings and depressing domestic activity.

Under this self-reinforcing process, both land and stock prices lost contact with reality. Nippon Telephone and Telegraph (NTT) is priced at more than 300 times earnings and a tennis court in the Tokyo area is worth $10m (£6m). If expectations of further price increases are not fulfilled, a downward revision will touch off a self-reinforcing process in the opposite direction.

Why did the authorities allow the situation to get out of hand? Partly because of external pressures—the US ill-advisedly insisted that Japan lower its interest rates in order to protect the dollar. Partly because of the goals of the Japanese establishment, which wants Japan to become number one in the world, but fears the Japanese will go soft through increased spending before they get there.

But perhaps the most important factor is the institutional role that the authorities play in the economy. They are used to managing it, not regulating it. This is particularly true of their relationship with the banking system. The stock and bond markets are also managed to a greater extent than in any other developed country. Growing international influences have rendered the task of managing the economy more complex.

Resistance to the land and credit boom has intensified. Domestically, the rise in housing costs and the widening gap between the haves and have-nots has become highly unpopular—the opposition Social Democrat Party is gaining ground. Internationally, central banks have been pressing for co-ordination of banking regulations and agreement has been reached.

The authorities have begun to take corrective steps: the growth of bank lending is being restricted through “window guidance”; tokkin funds have been obliged to publish their unrealized losses since September 30 and will have to offset them against realized gains before paying dividends as of March 31 next year: commercial banks will have to reduce their balance sheets or increase their capital base to conform to international standards.

Excesses usually make themselves felt when they are being corrected. That is the case now.All three sources of liquidity are beginning to dry up. International exchange rates have stabilized, domestic credit expansion is abating and even the savings rate can be expected to decline as housing sales rise and consumption picks up. Tokkin funds and mutual funds, the two main sources of institutional demand for stocks since 1985, topped out in July.

At the same time, the supply of shares is rising sharply, The giant second tranche of the NTT privatization issue equals in size the entire volume of new issues last year; and commercial banks will have to raise large amounts of additional capital. The demand/supply balance for stocks is shifting radically.

There have been two occasions since the beginning of 1986 when the stock market underwent a correction: September 1986 and July of this year. Both were short and shallow, reinforcing the belief that the bull market is invincible; both coincided with a period of stable or declining yen.

This time, exchange rate stability has been accompanied by a collapse in the bond market: the yield on the benchmark Coupon 89 rose from 2.6 per cent to more than 6 per cent. The collapse has revealed considerable speculative excesses. Large long positions in September futures could not be sold and the holders had to take delivery. A number of weaker players are in financial difficulties. Yet the stock market continues to flirt with new highs.

Continuing strength of the stock market is ominous because it implies that it may no longer be able to tolerate even a modest correction. The NTT issue is scheduled for November 9 and it is customary to stabilize markets in connection with new issues. This is achieved through a network of mutual obligations, involving practices which have been outlawed in other countries, notably the US, because they led to the crash of 1929. Should some parties be unable to live up to their obligations, the system could break down with every participant running to save himself.

The shift in the demand/supply balance can be restricted for a while by using up cash reserves. But unrealized losses are mounting not only in bonds but also in asset-related and financial stocks, which have fallen by about one third from their recent highs—and the unrealized losses will become real at the end of March 1988.

The rise in Japanese interest rates has already affected the bond and stock markets of other countries. It is difficult to see how the Japanese land and stock market boom can continue. A bust is looming.